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Third party payer mechanisms are perhaps the most innovative business models popularized by the Internet.

They can be seen as online Robin Hoods, charging rich corporations and using their revenues to provide individual users with everything from free search, to free office apps, to free YouTube videos, to well, who knows what else. Alternatively, they can be seen as just short of RICO violators, charging corporate users virtually unlimited fees for protection from online invisibility.

The truth is surely somewhere in between. But third party payers have had undeniably expensive consequences for the total cost of search, and are about to transform many genres of the marketing of consumer services.

Search and the underlying keyword auctions do not initially appear to cost consumers anything; there is no line item on a hotel bill for the hotel chain’s cost of online search keywords. Most consumers and many regulators believe they have no reason to care what keyword auctions cost. The costs of search, of course, are paid, but they are not paid by the users — this makes search costs of limited interest to consumer advocates or to regulators.

And yet, both advocates and regulators should be extremely interested in search as well as third party payer online business models. By separating the user and the payer, these business models make the price of search essentially irrelevant. Users use any search engine they choose because it’s free, and bidders for keywords pay whatever they have to for access to those users since there is no cost-effective alternative. Bottom line: If you want to be found, you pay to play where the searchers are. This separation of user and payer effectively decouples the price of search from the discipline of the market.

High Price for What Gain?

We all search for hotels online. Hotels need to be found, especially by first-time guests and by brand switchers with limited loyalty, so the hotels bid for keywords. As a result, all legitimate hotel operators have to bid for keywords — including bidding for their own names so that we can find them when we search. But what does the hotel industry gain from bidding? What does the hotel industry get for the hundreds of millions of dollars it is forced to pay? Absolutely nothing!

Absolutely nothing? That’s got to be wrong.

Nope. Nothing. The way it works is this. Each search engine has its own “secret sauce” for quality adjustment, and as long as each hotel “bids enough” for its own keywords, each is ranked exactly where it should be and exactly where it would be if there were no keyword auction. In other words, if the auctions worked perfectly, after each auction each hotel occupies the same spot it would if nobody bid anything.

With a hundred million here, and a hundred million there, search may be the best possible business — you don’t seem to pay anything, so you don’t care what search costs; the hotels are often properly ranked as long as they agree to play, so you don’t care about paid search rankings either; and search engine vendors get to siphon tens of billions of dollars out of the global economy for returning paid search results in approximately the same order the results would appear if search were free. Indeed, even with Google on a perpetual buying spree, they do not seem to be able to spend money as quickly as they collect it through paid search.

So Why Not Just Stop Paying?

Why can’t hotels just stop paying for keywords? Either one of two things would have to happen before hotels could risk this:

We could all stop relying on paid search to find things — and that’s just not going to happen. Google has long understood the importance of keeping paid search as good as possible and free search no better than it has to be, in order to sustain paid search as a business model. Consumers are going to continue to cooperate with Google’s business model.

Or all hotels could refuse to bid for keywords, and that’s not going to happen either. The rewards for being the first hotel to cheat, and the first to bid for competitors’ keywords, are just too tempting. As long as consumers are going to continue to cooperate with Google’s business model, firms are going to continue to do so as well.

Of course, this is not free to you. Hotels, airlines, and some other users pay to regain control over their brands, and much of this new expense is passed on to hotel guests. (In the form of a city room tax or potentially up to a $20 per night room key surcharge from their electronic key vendor).

So Why Can’t a New Entrant Crush the High-Price Vendor?

Why can’t a new search vendor compete? Throughout history, monopolies and monopoly pricing has been unsustainable unless there are serious entry barriers that prevent a competitor from introducing a newer, better, and cheaper alternative. Why is this different?

First, how could search be cheaper than it already seems to users? It’s not only free; it’s cheaper than free. Google uses its extraordinary profits to subsidize a range of other offerings, from the totally unrelated (YouTube), to the not-so-clearly integrated (using Gmail to make advertising better targeted and more effective), to the preemptive (buying the still emerging market for smart phones with subsidized Android offerings). So the users are going to stay with Google.

Second, as long as users stay with Google, bidders have to bid. Maybe a new search engine would be cheaper for bidders, but the benefits to bidders do not affect users. That’s the power of third party payment systems, with the objects of search paying all the costs through bidding for keywords (party three), not searchers (party one) or search system operators (party two).

This Has Occurred, and Been Regulated, Before

Yes, we’ve seen third party payer systems before, with computerized travel agent reservations systems (CRSs). Airline reservations systems in the 1980s had exactly the same business model, with airlines paying to be listed. The actual users — travel agencies — received their systems at prices that were, again, lower than free when subsidized services and over-rides from system vendors were included. And yes, the reservations systems operators were able to charge monopoly prices even though they did not enjoy formal monopolies. And yes, lower price alternatives became available, but as long as the agencies stayed with the two dominant vendors (Sabre and Apollo), those vendors were free to charge other airlines almost whatever they wanted, and as long as they subsidized the agencies, the agencies were willing to stay with Sabre and Apollo. Sabre earned more selling other airline’s flights than the operators of those flights made from flying; both American and United made more selling other airlines’ flights than they did from operating their airlines.

Ultimately, the courts ruled that CRSs were an essential facility, and that the prices that airlines were forced to pay represented monopoly abuse of this essential facility. Eventually, airlines were granted relief from the stranglehold of CRSs over agencies’ search. Similar relief may be appropriate for firms forced to bid on search keywords; see a post on CRSs, Google, and antitrust for more details.

Search represents third party payer systems at their most familiar. We have to search. And airlines, hotels, and other sellers and service providers have to pay for keywords. Because the third party actually pays, and the first party pays nothing, there is no direct marketplace discipline for the price of search terms or for the price of search generally. Most interestingly, neither the searching public nor the objects of search is better off than if search were competitively priced.

So that’s why these third party payer systems are so dangerous. Once they are established they are safely divorced from the pricing discipline of the market, lower priced competitors cannot succeed, and we all end up paying too much. Curiouser, and curiouser. Like Alice down the rabbit hole, we have no idea how to escape.

Welcome to the world of third party payer business models. Search is only the most familiar and best established. Group buying and other forms of online promotion are coming up fast.